What Is a Section 1231 Gain and How Is It Taxed?

A Section 1231 gain is the net gain from selling or exchanging business property held longer than one year, and it gets the best deal in the tax code: when your Section 1231 gains for the year exceed your Section 1231 losses, the net amount is taxed at long-term capital gains rates rather than ordinary income rates. Flip the outcome, and a net Section 1231 loss is fully deductible as an ordinary loss, with none of the $3,000 annual cap that limits capital losses. For 2026, the preferential rates top out at 0%, 15%, or 20%, compared with ordinary rates that reach 37%.¹

What Property Qualifies

Two conditions have to be met. The property must be used in a trade or business, and it must be held for more than one year. The most common qualifying assets are depreciable items like machinery, equipment, office buildings, and warehouses, along with non-depreciable business real estate such as raw land used in operations.²

Several less obvious categories also qualify:

Timber, coal, and domestic iron ore subject to the special rules under Section 631.
Cattle and horses held for draft, breeding, dairy, or sporting purposes for at least 24 months from acquisition.
Other livestock (except poultry) held for those same purposes for at least 12 months.
Unharvested crops sold or exchanged at the same time and to the same person as the underlying farmland, provided the land was held more than one year.²

The statute expressly excludes inventory and other property held primarily for sale to customers, creative works like copyrights and literary compositions in the hands of the creator, and certain government publications received without purchase.²

How the Netting Produces a Gain or Loss

Section 1231 treatment doesn’t apply transaction by transaction. You combine every Section 1231 gain and loss for the tax year into a single net figure. If the total gains exceed the total losses, every item in the group is treated as a long-term capital gain or loss. If the losses equal or exceed the gains, every item receives ordinary treatment.³

This all-or-nothing structure is the whole engine. A single large loss can flip the year’s Section 1231 results from capital to ordinary, and a single large gain can pull accompanying losses into capital treatment. The calculation is performed on Part I of IRS Form 4797 before any figures carry to Schedule D or Schedule 1 of your return.⁴

Tax Rates When You Have a Net Gain

A net Section 1231 gain is taxed as a long-term capital gain. For 2026, the rate brackets are:¹

0% on taxable income up to $49,450 (single), $98,900 (married filing jointly), or $66,200 (head of household).
15% above those thresholds up to $545,500 (single), $613,700 (married filing jointly), or $579,600 (head of household).
20% on taxable income above the 15% ceilings.

Set that against ordinary rates that run as high as 37%, and the advantage on the sale of a building or a major piece of equipment held for years is substantial.

Tax Treatment When You Have a Net Loss

A net Section 1231 loss is treated as an ordinary loss. It’s fully deductible against wages, business income, and other ordinary income, with no annual cap. Capital losses on stocks and other investment assets, by contrast, are limited to $3,000 per year ($1,500 if married filing separately) beyond what you can offset against capital gains.⁵ Section 1231 losses face no such restriction, and a net Section 1231 loss can also feed into a net operating loss if total deductions exceed total income for the year.

Depreciation Recapture Comes First

Before any Section 1231 gain reaches the favorable rates, the IRS claws back prior depreciation deductions through the recapture rules. The logic: if you deducted depreciation at ordinary rates over the years, that benefit is repaid before you get capital gains treatment on the sale.

Section 1245 Property

Section 1245 covers tangible personal property like equipment, vehicles, and machinery. On a gain sale, the portion of the gain attributable to prior depreciation is taxed as ordinary income. If the total gain is smaller than the depreciation claimed, the entire gain is ordinary. If the gain exceeds total depreciation, only the depreciation amount is recaptured; the rest moves into the Section 1231 netting process.⁶

Say you sell equipment for $50,000 with an adjusted basis of $30,000 after $20,000 in depreciation. The $20,000 gain equals total depreciation, so all of it is recaptured as ordinary income and nothing reaches Section 1231. Sell it for $60,000 instead, and the first $20,000 is ordinary recapture while the remaining $10,000 enters the Section 1231 pool.

Section 1250 Property

Section 1250 covers depreciable real property such as commercial buildings and rental properties. Recapture here is less aggressive because most real property is depreciated on the straight-line method. Under Section 1250 itself, only the excess of accelerated depreciation over straight-line is recaptured as ordinary income, and for property placed in service after 1986 that amount is typically zero.⁷

The remaining depreciation doesn’t escape entirely, though. The “unrecaptured Section 1250 gain,” meaning the gain attributable to straight-line depreciation, is taxed at a maximum rate of 25% rather than the usual 0%, 15%, or 20%.⁸ Only the gain exceeding total accumulated depreciation reaches the standard long-term capital gains rates through Section 1231 netting. Detailed depreciation records across the life of the asset are essential; without them, the IRS will generally assume maximum depreciation was taken.

The Five-Year Lookback

Without a check, Section 1231 would let a taxpayer deduct ordinary losses in some years and enjoy capital gains rates in others. Section 1231(c) supplies that check. Any net Section 1231 gain in the current year is recharacterized as ordinary income to the extent you claimed net Section 1231 losses during the five preceding tax years that haven’t already been recaptured.²

Suppose you reported a $15,000 net Section 1231 loss three years ago and deducted it as ordinary. This year you have a $40,000 net Section 1231 gain. The first $15,000 is taxed at ordinary rates to recapture the earlier benefit. The remaining $25,000 qualifies for long-term capital gains treatment. This applies whether or not the current gain involves the same assets that produced the earlier loss. The IRS tracks nonrecaptured losses on lines 8 and 9 of Form 4797, Part I; if you’ve had Section 1231 activity across multiple years, keeping your own running total prevents surprises.⁴

Sales to Related Parties Lose 1231 Treatment

Selling depreciable property to a related party strips the capital gains benefit entirely. Under Section 1239, the gain on a sale of depreciable property between related persons is taxed as ordinary income, not as a Section 1231 gain.⁹

“Related persons” reaches broadly: a taxpayer and any corporation or partnership the taxpayer controls with more than 50% ownership (directly or indirectly), trusts where the taxpayer or spouse is a beneficiary, and estate executors selling to estate beneficiaries. The rationale is that selling depreciable property to a related entity would let the buyer take fresh depreciation deductions while the seller pays tax at capital gains rates, a combined benefit Congress treated as abusive.⁹

The 3.8% Net Investment Income Tax

Higher-income taxpayers should figure the Net Investment Income Tax into the true cost of a Section 1231 gain. NIIT adds 3.8% on net investment income when modified adjusted gross income exceeds $200,000 (single), $250,000 (married filing jointly), or $125,000 (married filing separately).¹⁰

Whether a Section 1231 gain triggers NIIT depends on the activity. Gains from a passive trade or business are included in net investment income and subject to the tax. Gains from a business in which you materially participate are generally excluded. For a landlord who doesn’t qualify as a real estate professional, the gain on selling a rental building would likely be subject to NIIT on top of the capital gains rate, pushing the effective federal rate to as high as 23.8% before considering the 25% layer on unrecaptured Section 1250 gain.

Where the Numbers Go on Your Return

Every Section 1231 transaction flows through IRS Form 4797:⁴

Part I holds Section 1231 gains and losses from sales or exchanges of business property held more than one year. The netting happens here, and the five-year lookback is applied here.
Part III computes depreciation recapture under Sections 1245 and 1250. Recapture amounts move back to Part I or Part II as ordinary income before any remaining gain enters the Section 1231 pool.
Part II holds ordinary gains and losses, including property held one year or less and amounts recaptured out of Part III.

A net gain from Part I transfers to Schedule D as a long-term capital gain. A net loss flows to Schedule 1 (Form 1040) as ordinary income.¹¹

Qualified Opportunity Zone Deferrals Come Due in 2026

Section 1231 gains have been eligible for deferral through investment in Qualified Opportunity Funds since the program’s creation in 2017. The deferral program’s mandatory inclusion date is December 31, 2026. All remaining deferred gains, regardless of when the QOF investment was made, must be recognized no later than that date, and eligible gains must have been recognized before January 1, 2027, to have qualified for deferral in the first place.¹²

If you previously deferred Section 1231 gains into a QOF, 2026 is the year those bills come due. Coordinate the recognition event with any other Section 1231 activity expected in the same year, because it will affect the netting calculation.

1
Internal Revenue Service. Revenue Procedure 2025-32
2
Office of the Law Revision Counsel. 26 USC 1231 – Property Used in the Trade or Business and Involuntary Conversions
3
eCFR. 26 CFR 1.1231-1 – Gains and Losses From the Sale or Exchange of Certain Property Used in the Trade or Business
4
Internal Revenue Service. Instructions for Form 4797
5
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
6
Office of the Law Revision Counsel. 26 USC 1245 – Gain From Dispositions of Certain Depreciable Property
7
Office of the Law Revision Counsel. 26 USC 1250 – Gain From Dispositions of Certain Depreciable Realty
8
Office of the Law Revision Counsel. 26 USC 1 – Tax Imposed
9
Office of the Law Revision Counsel. 26 USC 1239 – Gain From Sale of Depreciable Property Between Certain Related Taxpayers
10
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
11
Internal Revenue Service. Form 4797 – Sales of Business Property
12
Internal Revenue Service. Opportunity Zones Frequently Asked Questions